Irrational behavior in Crimea may damage Russian economy

By Sergei Guriev /

Mon, Mar 17, 2014 - Page 9

The debate around Crimea is no longer centered on international law: Russian President Vladimir Putin has publicly recognized that he does not feel bound by it and does not care if the rest of the world deems Russia’s actions illegal. What is not clear is whether Russia’s economy can bear the burden of Putin’s objectives in Ukraine.

The economic damage to Russia will be vast. First, there are the direct costs of military operations and of supporting the Crimean regime and its inefficient economy, which has been subsidized by the Ukrainian government for years. Given the uncertainty surrounding Crimea’s future status, these costs are difficult to estimate, although they are likely to total several billion US dollars per year.

A direct cost of this magnitude amounts to less than 0.5 percent of Russia’s GDP, not a trivial sum, but Russia can certainly afford it. Moscow just spent US$50 billion dollars on the Sochi Olympics and plans to spend even more for the 2018 FIFA World Cup. It was prepared to lend US$15 billion to ousted Ukrainian president Viktor Yanukovych’s government and to provide Kiev with US$8 billion annually in gas subsidies.

Although the scope of any possible sanctions remains uncertain, the effect could be enormous. Annual inward foreign direct investment in Russia is estimated to have reached US$80 billion last year. A significant decline in such investment — which brings not only money, but also modern technology and managerial skills — would hit the country’s long-term economic growth hard. Also, denying Russian banks and firms access to the US and possibly EU banking systems — which is the harshest sanction applied to Iran — would have a devastating impact.

However, in the short run it is trade that matters more than investment. Russia’s annual exports (mostly oil, gas, and other commodities) are worth almost US$600 billion, while annual imports total almost US$500 billion. Any non-trivial trade sanctions — including sanctions on Russian financial institutions — would be more painful than the direct cost of subsidizing Crimea. Of course, sanctions would hurt Russia’s trading partners, too, but Moscow’s dependence on trade with the West is certainly much larger than vice versa.

Moreover, the most important source of potential damage to Russia’s economy lies elsewhere. Lack of confidence in Russian policymaking is the main reason for capital flight, low domestic asset prices, declining investment and an economic slowdown that the Crimean crisis will almost certainly cause to accelerate.

Russia’s response to events in Ukraine exceeded the worst expectations of those questioning whether Putin is, as German Chancellor Angela Merkel put it, “in touch with reality.” The move to annex Crimea has reversed any soft power benefit that Putin might have gained from the Sochi Olympics.

Since the crisis began, Russia’s leaders have repeatedly contradicted their previous statements, backtracked, reversed decisions and denied easily verifiable facts. This indicates they have no strategy and do not foresee the consequences of their decisions. Even the Kremlin’s own supporters acknowledge that Putin “is improvising.”

It is also clear that the decisions to violate international law, despite the risk of economic isolation, were made in an ad hoc fashion by Putin’s innermost circle. For example, Valentina Matviyenko, the chairwoman of the Russian Federation Council — the parliament’s upper house — announced that Russia would not send troops to Ukraine just two days before she and the council voted unanimously to authorize Putin to do precisely that. Matviyenko is one of the 12 permanent members of Russia’s National Security Council, the supreme decision making authority on such matters.

Regardless of whether the Kremlin is irrational or simply uninformed, its policy in Crimea sends an unmistakable signal to investors: Russia’s political leaders are impossible to predict. This will further undermine Russian and foreign investors’ confidence and increase capital flight, which could not come at a worse time. With credit-fueled consumer spending — the engine driving GDP growth since 2010 — now running out of steam, the economy is stagnating.

Meanwhile, investment is still below its 2008 peak. Despite a wealth of opportunities across the Russian economy, the country’s hostile business climate — including bloated bureaucracies, widespread corruption and the expansion of state-owned companies — has weakened Russian and foreign investors’ incentive to start new projects or expand existing ones. The realization that Putin has entered, to quote Merkel again: “another world,” will not help.

Will Russians notice the economic costs of the Kremlin’s irrationality? GDP growth has slowed and may turn negative, while the stock market has fallen sharply and may decline further. Of course, equity ownership in Russia is narrow; most Russians do not even follow market indices. Yet increased capital flight will also affect something that ordinary Russians know and care about: the ruble’s exchange rate.

On the Monday after Putin’s Crimean adventure began, the Central Bank of Russia reportedly spent US$11.3 billion to prop up the ruble. Such support is clearly unsustainable and the bank recently announced that it will allow the ruble to float, implying an exchange rate that reflects the market’s expectations concerning oil prices and future capital outflows.

Therefore, worries about a Putin who has “lost touch with reality” imply not only a lower or even negative GDP growth rate, but also — more immediately — a weaker currency that would drive up prices of imported consumer goods. All Russians will soon feel the effects of this, but whether that will bring their president back from his world to this one is another matter.

Sergei Guriev, a visiting professor of economics at Sciences Po in Paris, is also a professor of economics and a former rector at the New Economic School in Moscow, Russia.